Dividends — Who Cares?
When a startup seeks financing, at some point the topic of dividends may come up. It seems everyone has heard of dividends, but who really cares about them? Generally, dividends are not as important as many of the other term sheet provisions, but you may encounter an investor who gets hung up on them (private equity types love dividends, while venture capitalists typically couldn’t care less). Why?
First, what is a dividend? A dividend is a distribution of the company’s cash or stock to its shareholders. Seems simple. But, naturally, lawyers have made it more complicated than that. For example, there are cumulative and non-cumulative dividends. With a non-cumulative dividend, if the company does not declare a dividend during the fiscal year, then the right to the current dividend is relinquished. On the other hand, with a cumulative dividend, the right to receive the dividend is accumulated until it is paid or terminated. This all sounds important, but in reality, early-stage startups rarely have any cash to distribute, and stock dividends lead to dilutive problems.
Dividend language may look something like this:
Series A Preferred Stock will carry an annual [insert dividend percentage, typically in the range of 8%]% cumulative dividend [compounded annually] of the Original Purchase Price in preference to any dividend on the Common Stock payable upon a liquidation or redemption. For any other dividends or distributions, the Series A Preferred Stock will participate with Common Stock on an as-converted basis.
So why am I questioning the importance of dividends? Because dividends cannot provide the type of return that venture capitalists are looking for. This can be shown by doing some easy math. Assume a dividend of 10% (dividends typically range from 2.5% to 15%, depending on the investor – using 10% keeps the math easy). Venture capitalists are typically swinging for the fences, not trying to generate returns for their investors from their companies cashflow. A successful return in a VC’s mind is likely closer to 10x her investment, not 10% per annum.
Assuming your VC receives a favorable 10% automatic annual cumulative dividend (without the compounding aspect to keep the math simple), it would take the VC 100 years to get her 10x return through the dividend. With a 10% dividend, a VC will only get 1x her investment if she holds the investment for 10 years. In general, a venture deal has a 5 to 7-year lifespan; with a 10% automatic annual cumulative dividend, the VC will never reach the 10x return from the dividend alone.
When can a dividend matter? Dividends can create and build an internal rate of return on an investment that will be realized upon redemption or exit through sale or an IPO. In other words, a dividend can provide downside protection to the investor. Let’s consider a $50M investment with a 15% cumulative dividend that is acquired after three years for $100M. If we assume a straight (or non-participating) liquidation preference and that the investor received 33.3% of the company for her investment (a $150M post-money valuation). Because the $100M sale price is less than the $150M post-money valuation at the time of the investment, the investor will use her liquidation preference to receive her original $50M plus any accrued dividends. In this case, the accrued dividends, assuming they were accumulating and not being paid, would be $22.5M ($7.5M per year for 3 years). Here, if the VC did not have a dividend, the VC would have foregone an additional $22.5M to protect this (losing) investment.
Well if a dividend provides downside protection, then why wouldn’t it be an important provision? Because we are assuming the company can or should actually pay out a dividend. As mentioned above, dividends can be paid out in cash or stock, usually determined by the company. If the dividend is paid out in stock, it leads to additional dilution of ownership. If the dividend is paid out in cash, it might be depleting the company of necessary resources.
An automatic dividend can also cause significant trouble for the company. It’s important to include any automatic dividends in a solvency analysis, as an automatic cumulative dividend could unknowingly thrust you into insolvency.
Many VC’s recognize that by insisting on receiving a dividend, they may actually lower their return on investment by sucking the company dry. Dividends are more common in private equity investments because the investment amounts are typically larger (typically greater than $50M) and less risky. The larger the investment and the lower the expected exit multiple, the more a dividend comes into play.
If an investor insists on receiving a cumulative dividend from your early-stage startup, know that the investor might not have your growth as a high priority. Make sure you do the math and understand how the dividend may impact your piece of the pie upon an exit. And just because everyone has heard of a dividend, doesn’t mean every company should be offering one.